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Monday, November 10, 2008

The Warren Buffett Way: Chp 5 Part 3: Permanent Holdings

The Coca-Cola Company:

Coca-Cola's business is easily understood. The company takes in raw materials such as water and sugar (among other ingredients) and produces drink concentrate, soft drink syrups and carbonated beverages. The company has a long track record of dominant market presence as well as profitability. The Coca-Cola company sold their first soft drink product in the United States in 1886. The company has an incredibly strong brand name with an impressive worldwide distribution network.

Leadership of Coca-Cola was generally considered to be of poor quality during the 1970's. During this period, management made several questionable investments using shareholders' retained earnings. The questionable investments were made in projects with slim profit margins and included ventures such as investing in a shrimp farm. Despite the lack of effective management, the company was still profitable.

However, in the 1980's, there was a change of leadership with Roberto Goizueta and Donald Keough, both of whom brought in dramatic positive change at the company. They focused on improving the company's operating performance (cost-cutting was one aspect) and on improving shareholder returns. The effectiveness of this management team did not go unnoticed by Warren Buffett.

Under the new leadership, there was a renewed focus on investing in the core business, optimizing returns on equity and empowering management to be proactive rather than reactionary. In 1980, the return on equity of the company was around 20%. In 1988, under the new leadership, Coca-Cola's return on equity had increased dramatically to 31.8%. From 1980 to 1988, $1 of retained earnings resulted in the creation of $4.66 of market share.

The renewed core operating focus at Coca-Cola resulted in significant growth of net cash flow. The cash flow was put to use by initiating the first ever stock buyback program in 1984, increasing shareholder dividends and reinvesting in the business. Since 1984, the company has bought back 25% of their shares.

In 1988, the time when Buffett made his investment in Coca-Cola, the company had a price to earning ratio of 15 times and a price to book ratio of 5 times. On the surface, this didn't seem to be a value play, but as Buffett has said, the value of a company has nothing to do with price and everything to do with what the expected future discounted cash flows will be during the life of the business.

In 1988, Coca-Cola produced owner earnings of $828 million at a time when the long term U.S treasury rate yield was around 9%. Coca-Cola grew owner earnings at a annual rate of 17.8% between 1981 to 1988.

Using the Coca-Cola's 1988 owner earnings, the 9% treasury yield as a cash flow discount and a growth assumption for owner earnings of 10% for 10 years followed by 5% thereafter, results in a value for the company of $32.5 billion. At the time Buffett purchased Coca-Cola in 1988, the market cap of the company was just $14.8 billion.

According to Buffett, "the best business to own, is one that over time can employ large amounts of capital at very high rates of return". This fits the description of the Coca-Cola Company.

3 comments:

The economic moat (competitive advantage) that currently surrounds Coca-Cola is its strong brand name and the buying loyalty of the Baby Boomers. Remember the fiasco with "New Coke" and how "Coca-Cola Classic" had to be created to fix it.

Generation X treats soft drinks more as a commodity and is not as brand loyal as the Baby Boomers. But this is ok because they are a much smaller group than the Baby Boomers. Therefore, Coca-Cola still dominates today in the "cola wars."

However, Buffett pays careful attention to “what the economics of the industry will be 10 years down the road, and who will be making the money at that point.”

Within ten years, Generation Y will be the dominate group purchasing soft drinks. Generation Y is even less brand loyal than Generation X. The commoditization of the soft drink market will destroy Coca-Cola's economic moat, which will cause their earning yields to fall to levels near their competition.

By the way, both my wife and myself are Baby Boomers. We are both Coca-Cola product drinkers. We both boycotted "New Coke" when it came out. I switched to Royal Crown Cola and my wife to Pepsi. When the Classic Coke came out, we switched back to Coca-Cola.

Our three children are all Generation Y. They can care less about what brand of soda they drink. When I asked them, they said that their friends are all the same way.

I know that this is just anecdotal evidence, but there are numerous trade studies showing Generation Y's buying habits are very low in brand loyal.